A Warning for Stock Bargain Hunters

Yesterday the U.S. Federal Reserve Board, The Bank of England and the European Central Bank all lowered their key interest rates by a half point. This is the first time since September 11, 2001, that the major Western central banks have taken this kind of coordinated action.

Like all rate cuts, this one cuts both ways, both reassuring the financial community that extraordinary action is being taken, and scaring the hell out of everyone that extraordinary action is considered necessary. Investors, both individual and professional, like to think of themselves as cool and rational, but they’re soothed by helpful gestures like everyone else.

I’ve been looking at stock charts the past two days, and I’m struck with the number of big name stocks that are trading at extremely low P/E ratios.

Now, as you know, we don’t consider P/E ratios a part of our growth stock investing disciplines. Growth stocks are expensive, and we’ve made some excellent money in stocks with P/E ratios that were over the moon!

But when an enormous blue-chip stock like General Electric (GE), which pays a substantial 6.1% annualized dividend, is sporting a P/E ratio of 9 (!), there is a lot of value available for interested buyers. Warren Buffett is one.

On the growth side there are also stocks in promising technology sectors whose companies have posted triple-digit earnings growth for two or three quarters but are still falling down the stairs with no support in sight.

The opportunities are huge.

But here’s the big warning: Don’t Act Until the Market Actually Turns!

In this kind of market, stocks that are at historically low levels can still fall farther. The only downside limit on a stock’s price is zero. Anticipating the turn is throwing the dice with the odds against you.

Patience is an underestimated virtue, but this is the kind of market that richly rewards it. Get into cash. Stay there. Wait for the market to make a convincing upmove before you get back in. It’s not easy, but it’s the right thing to do.

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I have a friend who’s an avid tennis player, the kind of guy who routinely finishes high in his club championships and sometimes wins. But he has always believed that with just a little advice from a top tennis coach he could be a truly great player.

He got what he wanted (in a way) when he attended the 2004 U.S. Open Tennis Tournament in New York and got a great seat at one of the quarterfinal matches, in the second row behind the end line. He realized that he was sitting two seats away from Andy Roddick’s coach (and brother), John Roddick. This, he hoped, might be his chance to overhear what a top coach had to say to a top player.

And he did.

After Roddick lost the first two sets, his brother screamed at him during the changeover, “Keep your eye on the ball!” Roddick eventually lost the match (to Joachim Johansson), but not before coming back to even the match at two sets apiece.

The lesson? Even at the highest levels of any enterprise, the most basic things are still the most important. If you’re looking for some inside trick that great growth stock investors use to make more money than the rest of us, you’re probably wasting your time. There is no Holy Grail, no Philosopher’s Stone.

But if you asked my opinion on the most important basic rule, the one that’s the equivalent of “keep your eye on the ball,” I couldn’t pick one … but I could pick three. And here they are.

1. Follow the market’s trend. If you buy when the market is going up, you put the odds on your side, because a bull market changes the odds. It’s always easier to swim with the tide or run with the wind at your back. Stock markets are no different. And when markets are going down, you should work extra hard to weed out your losers and move toward cash for the same reason.

2. Cut your losses short. When a stock starts falling, you have no idea how far it might go. The only theoretical limit is zero. And the longer you stick with it, the less capital you have to put to work. No matter how much it hurts–and it does hurt, I know from personal experience–you have to admit that you made a mistake and sell the stock when it reaches your sell point. Cabot’s growth investing rules advise selling when you have a loss of 20% in bull markets and 15% in bear markets. But these are the absolute limits; we often sell at a 5% or 10% loss if the market has turned sour or a stock has been hit by bad news. Calculate the sell point when you buy the stock, write it down and stick to it. The number of times you get shaken out of a stock that then starts rising again will be more than made up for by the number of times you save your money to fight another day.

3. Let your winners run. Some investors set buy points as well as sell points. When a stock is showing a 20% profit, or 25%, or whatever, they will sell the stock and book the profit. While booking a few smaller profits is fine, doing it across the board makes it impossible to enjoy the wealth-building benefit of a stock that doubles and then doubles again, which is how really enormous gains are made. The profit from these big gainers, which reward you with compound growth, is what makes aggressive growth investing a winning proposition. It takes just one of them to compensate you for a bunch of stocks that fall short.

There’s a reason that the same old rules are still the rules. Keep it simple. Keep your eye on the ball. And you’ll come up a winner.

Now all we need is that bull market …

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You Bet Your Life

The world of life insurance is mostly boring statistics, actuarial tables and creepy TV commercials. But there are also some exotic twists in the insurance world, and one of them is the basis for my investing idea.

The twist is the viatical settlement, an old idea that got a new lease on life (sorry) when the AIDS crisis first flared up. The idea was that AIDS patients–who had limited life expectancies before today’s medications were developed–would sell the rights to their life insurance settlements, then take the money and use it for medical expenses, or a last vacation, or whatever they wished.

Interest in viaticals flagged once AIDS became a survivable illness, and it has taken the aging of the Baby Boomers to revive it. Using viaticals and another transaction called a life settlement (in which people over 65 years old and with a life expectancy of less than 15 years take a lump sum in return for the right to their life benefit) a company called Life Partners (LPHI) has established a thriving business.

Texas-based Life Partners has done very well with offering this option to elderly people with multiple policies, expiring term policies or plans to make charitable donations. LPHI has had its ups and downs, but its current run has taken it from 12 to 36 before a correction in the past couple of days. Revenues and earnings are growing and institutional support is scarce, leaving lots of room for growth. Unfortunately, the stock trades just 82,000 shares a day, on average, which will probably keep it from qualifying as a recommendation in one of our growth publications.

Life Partners isn’t one of the emerging markets stocks that I usually follow and write about. But I’m always fascinated by the odd businesses that growth-investing research brings to my attention.

Sincerely,

Paul GoodwinFor Cabot Wealth Advisory

Editor’s Note: Paul Goodwin if the analyst and editor of Cabot China & Emerging Markets Report, which has managed a 25.3% gain for the 12 months ended August 31, despite the bear market. If you’d like to begin building a watch list of emerging markets stocks while this economic hurricane blows itself out, you might want to consider a trial subscription to the Cabot China & Emerging Markets Report. Our market timing strategy has kept our subscribers heavily in cash during this storm, and when the markets get healthy again, we’ll be ready. You can get a free, no-risk trial subscription by clicking on the link below.

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Paul Goodwin has been a researcher and writer for over 30 years. His Cabot Emerging Markets Investor will show you the vast profit potential of investing in countries whose economies are growing far faster than that of the U.S.

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Market Update

From Cabot Small-Cap Confidential:

The S&P 600 Small Cap Index is up in 20 of the last 24 days.

The stock market has been having quite the party over the past month. Since November 8, the date of the election, the S&P 500 is up by 4.8%. Small caps have crushed that performance, rising by almost 16% over the same timeframe. Much of that outperformance can likely be attributed to a more favorable relative valuation (as compared to large cap) heading into the election. And an even better outlook coming out, given what is expected to be a pro-growth administration. Given the outlook for a pro-USA administration as well, which favors small caps over large (given their 19% ex-U.S. revenue exposure vs. roughly 30% ex-U.S. for S&P 500), we essentially wound up with a pro-small cap-squared backdrop. Everything has been working.

Alert

Many top earnings winners pulled back during the two-day Brexit selloff. I want to initiate a bullish position in Applied Materials which stood out after
blowing away earnings estimates. While I like the stock, I believe that there may be limited upside in most stocks, so I want to initiate a buy-write,
which sells expensive options.

To execute this trade, you need to:
Buy AMAT Stock,
Sell to Open the August 23 Calls.

As is always the case, you can sell one call for every 100 shares of stock you buy. Or five calls for every 500 shares you purchase.

For example, you could buy AMAT stock at 23 and sell August 23 Calls for 1.00 (the math behind this net price is 23 minus 1 equals 22).
I expect you will get a better price than I'm recommending.

The most you can make on this trade is $1.00, a yield of 4.54% in just over a month if AMAT closes above 23 on August expiration.

If AMAT is unchanged on August expiration, we will have created a yield of 4.54%.

Breakeven on this trade is 22.

The most you can lose on this trade is $2200 per buy-write if AMAT were to go to zero.

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